One of the few consolations of last year's market fiasco is that many investors will be able to take a vacation from capital gains taxes this year. Investors who sell securities that have been relentlessly beaten down can use those losses to offset gains that have been realized in the same year. Many investors are using the bumper crop of losses realized in 2008 and the first part of 2009 to transition concentrated positions, rebalance their asset allocations, or move away from disappointing strategies-all with little or no tax bite. They are finding that even after offsetting gains realized in these transitions, they have excess losses that will carry forward to shelter gains realized in future tax years. How long are these losses likely to last?

Although each investor's tax situation is unique, our experience tells us that these excess losses, even a large carry forward, will get used quickly. Let's examine two market recovery scenarios: 2003 and 2009. After the tech bubble there was a bear market from 2000 to 2002 in which many people realized significant amounts of losses. But markets recovered sharply in 2003, returning 39.7% from March to December as measured by the Russell 1000 Index. For example, say you have a client with a $10 million portfolio that is actively managed and has a turnover of 80% (in line with the average manager in the Morningstar U.S. equity mutual fund universe). And say the client pays 15% tax on dividends and 35% on short-term capital gains. What is the expected after-tax experience in the 2003 recovery? In this scenario, you would expect more than $2.6 million in realized gains during 2003. If the investor had no realized losses to offset the gains, their returns would be reduced by 10% after considering taxes (see "Tax Liability Then and Now," on page 39).

An investor who had accumulated realized losses over the bear market years could likely have matched these realized gains with losses and wiped out their tax bill, but would probably not have many losses left over. This is a simple example, but demonstrates how quickly a recovery can start generating tax liabilities. The story is similar in the latter half of 2009. From March through September, the Russell 1000 was up 47%. With the same assumptions for turnover and tax rates, an investor's return would be reduced by 13% from taxes.

BEFORE YEAR'S END

Investors who realized capital losses, are unlikely to pay a big tax bill this year, despite the market recovery. Another point to consider is looming tax rate increases. The current tax law has a sunset provision, causing the 15% tax on long-term capital gains to revert to 20% at the end of 2010 if no legislation is passed to extend it. Given the government's projected 2009 budget deficit of about 13% of GDP-the highest since world war ii-it's unlikely that Congress will keep tax rates at their current low levels. So it's possible that just as investors burn through their loss carry-forwards, they will face the double shock of having to pay capital gains tax again and pay them at a higher rate. Those who take a long-term strategic view to tax management can avoid this tax shock.

Here are few things to consider as you wrap up the year:

* Check for losses. Even if the investor has a large amount of realized losses for 2009, review the portfolio before the end of the year for additional losses to realize.

* Maintain exposure. If you decide to realize losses, maintain the market exposure during the wash-sale period.

* Take some gains. If you have extra losses, you might consider using them by realizing some gains now. Even if you have no losses to shelter the gains, the current tax rate on long-term capital gains is at 15%, which is low compared with rates over the past 60 years.

* Accelerate income.Some clients may have the option to accelerate or defer income. With tax rates on ordinary income going from a maximum of 35% to 40%, it makes sense to realize the income this year at the 35% rate.

* Plan charitable giving strategy. Deferring discretionary deductible payments, such as charitable contributions, to later years will make them more valuable from a tax perspective.

THE LONG VIEW

To extend the capital gains vacation, we recommend continued tax management vigilance and the following specific ideas for the long term:

* Manage taxes throughout the year. Although the "year-end" approach to tax planning worked well in 2008, it is better to realize losses throughout the year. For example, the first two quarters of 2009 offered plenty of opportunities to harvest losses, but if you waited until the end of the year, those opportunities dried up as markets recovered. For example, if you were invested in a Russell 1000 ETF and waited until the end of the year to consider loss harvesting, you would have no losses to realize. However, if you had monitored it monthly, you could have realized an 8% loss in January and a 10% loss in February.